Give To The Children, Save On Tax Bill

Christmastime turns the mind to thoughts of giving. The end of the year turns the mind to thoughts of taxes. An incongruous juxtaposition? Not entirely. Give too much money to your children, for example, and you may wind up paying hefty federal gift levies. Give more modest amounts -- and do it cleverly -- and you can save on your income taxes.

The trick of this trade is called income shifting. If you are in the 50% tax bracket, for instance, your investments have to earn $2 for every dollar you can spend. An investment in your child's name, by contrast, turns a tot into a taxpayer, but one who is taxed at much lower rates. Since a parent can give each child $10,000 a year without paying federal gift taxes ($20,000 for a married couple), the principal can mount up fairly quickly.

So, you ask, what's in it for me?

Aside from having your child's undying gratitude, you get to use this tax-advantaged income to pay some of the bills you would otherwise pay with your own 50 cents-on-the-dollar income. College, summer camp, a Triumph sports car for a teenager -- "all these things, in effect, become equivalent to tax-deductible items because you're using low-tax dollars," says Harry G. Gordon, a Greensboro, N.C., attorney. The only requirements are that the expenditures be for the child's benefit, and that they not be part of what the law sees as a parent's ordinary obligations. So while you can't use your child's newly found income for food and clothing, for example, you probably can use it for private-school tuition or a piano.

Custodial account. The simplest way to transfer money to a minor child is to establish a custodial account under your state's version of the Uniform Gifts to Minors Act. This is simply a bank or brokerage account set up in the child's name, with a parent or friend managing the money and dispensing the funds. One caution: The person giving the money probably shouldn't be named as custodian. If the donor dies while serving in this capacity, the gift reverts to his estate.

An irrevocable trust. This is one step more complicated and, unlike a custodial account, should be drafted by a lawyer. Once established, though, it can be more flexible. A custodial account, for instance, is often limited by law as to what it can invest in. "You're sort of foreclosed from the kinds of things that are useful to put in a kid's name," observes Haig Der Manuelian, an attorney with the Boston firm of Widett, Slater & Goldman. "For example, you can't hold an interest in a piece of income-producing property." Most trusts face no such restrictions, and, in fact says Manuelian, may be an ideal repository for real estate or other assets that are likely to appreciate rapidly.

Another potential problem with custodial accounts, notes Sherwin Simmons, a Tampa tax lawyer, is that the principal in the account automatically falls under the child's control when he or she reaches the age of majority. So, while you may have college-tuition payments in mind when you set up the account, a rebellious 18-year-old may decide that a year in Europe would be more interesting than a year on campus. A trust, typically, can't be claimed until age 21 or beyond.

Clifford trust. With both custodial accounts and irrevocable trusts, you can't set them up one year and change your mind the next. "Irrevocable," as one lawyer put it, "means you can't get it back. And these are irrevocable devices." But if you can't afford (or can't bring yourself) to give away principal, don't despair. You can set up an interest-free loan. Or you can look into a clever device called a Clifford Trust, which, unlike most trusts, gives you your assets back after a minimum of 10 years. In the meantime, the income those assets generate can be used for the recipient's benefit, and are taxed at his or her lower rate.

There are some pitfalls to watch for here, too. "A lot of people will prepare a Clifford Trust that expires in 10 years and a day, then two days later put stocks in it. Or 2 years down the road they'll put more property into it," says Manuelian. "In both cases the property is in the trust for less than 10 years. This frustrates the donor's attempt to avoid income taxation on the income of the trust." Another danger: When a stock that has appreciated is sold by a Clifford Trust, in most cases it is the donor, not the trust, that is liable for capital gains taxes. And the tax is due immediately, not after the trust expires.

In principle, any of these arrangements can be set up with borrowed money, meaning that you can add an interest deduction to the tax break already provided by the trust or custodial account itself. Borrowed or not, however, no large sums should be passed on to your children without the advice of a lawyer specializing in these matters. To do it on your own is to risk that neither the gift nor the tax consequences will turn out as intended. And that could be enough to spoil your holiday season.